Principles of Managerial Finance Brief Edition

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Principles of Managerial FinanceBrief Edition

• Chapter 3

Basic Corporate Securities Stocks and Bonds
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Learning Objectives

• Describe the legal aspects of bond financing and
  bond costs.
• Discuss the general features, ratings, types, and
  international issues of corporate bonds.
• Differentiate between debt and equity capital.
• Review common stock ownership, par value,
  preemptive rights, and other important aspects of
  stock ownership.

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Learning Objectives

• Discuss common stock voting rights, dividends,
  and international issues.
• Understand the rights, features, and special
  types of preferred stock.

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Corporate Bonds

• Corporate bonds are debt securities issued by
  the corporation itself.
• Investors lend money to the corporation in
  exchange for a specified promised amount of
  (coupon) interest income.
• Most bonds are issued with face values of 1,000
  and maturities of 10 to 30 years.
• At the end of the bond term, investors receive
  the face value of the bond.

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Corporate Bonds
Legal Aspects

• The bond indenture specifies the conditions
  under which it has been issued.
• It outlines both the rights of bondholders and
  duties of the issuing corporation.
• It also specifies the timing of interest and
  principal payments, any restrictive covenants,
  and sinking fund requirements.

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Corporate Bonds
Legal Aspects

• Common standard debt provisions in the
  indenture typically include
• the maintenance of satisfactory accounting
  records
• periodically furnishing audited financial
  statements
• the payment of taxes and other liabilities when
  due
• the maintenance of all facilities in good working
  order
• identification of any collateral pledged against
  the bond

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Corporate Bonds
Legal Aspects

• Common restrictive provisions (or covenants) in
  the indenture typically include
• the maintenance of a minimum level of liquidity
• prohibiting the sale of accounts receivable
• the imposition of certain fixed asset investments
• constraints on subsequent borrowing
• limits on annual cash dividend payments

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Corporate Bonds
Legal Aspects

• An additional restrictive provision often
  included in the indenture is a sinking fund
  requirement, which specifies the manner in
  which a bond is systematically retired prior to
  maturity.
• Sinking funds typically dictate that the firm
  make semi- annual or annual payments to a trustee
  who then purchases the bonds in the market.

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Corporate Bonds
Cost of Bonds

• In general, the longer the bonds maturity, the
  higher the interest rate (or cost) to the firm.
• In addition, the larger the size of the
  offering, the lower will be the cost (in
  terms) of the bond.
• Finally, the greater the risk of the issuing
  firm, the higher the cost of the issue.

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Corporate Bonds
General Features

• The conversion feature of convertible bonds
  allows bondholders to exchange their bonds for a
  specified number of shares of common stock.
• Bondholders will exercise this option only when
  the market price of the stock is greater than
  the conversion price.
• A call feature, which is included in most
  corporate issues, gives the issuer the
  opportunity to repurchase the bond prior to
  maturity at the call price.

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Corporate Bonds
General Features

• In general, the call premium is equal to one
  year of coupon interest and compensates the
  holder for having it called prior to maturity.
• Furthermore, issuers will exercise the call
  feature when interest rates fall and the issuer
  can refund the issue at a lower cost.
• Issuers typically must pay a higher rate to
  investors for the call feature compared to
  issues without the feature.

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Corporate Bonds
General Features

• Bonds also are occasionally issued with stock
  purchase warrants attached to them to make them
  more attractive to investors.
• Warrants give the bondholder the right to
  purchase a certain number of shares of the same
  firms common stock at a specified price during
  a specified period of time.
• Including warrants typically allow the firm to
  raise debt capital at a lower cost than would be
  possible in their absence.

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Forms of Debt
Bearer Bonds

• Bearer bonds are often referred to as coupon
  bonds because they are not registered to any
  particular person.
• The coupons are submitted twice a year and the
  authorized bank pays the interest.

For instance, a twenty year 1,000 bond paying 8
interest would have 40 coupons for 40 each.
Bearer bonds can be used like cash. They are
highly negotiable. There are still many in
circulation. However, the Tax Reform Act of 1982
ended the issuance of bearer bonds.
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Forms of Debt
Registered Bonds

• Today, bonds are sold in a fully registered form.
  They come with your name already on them. Twice a
  year, you receive a check for the interest. At
  maturity, the registered owner receives a check
  for the principal.
• A partially registered bond is a cross between a
  registered bond and a coupon bond. The bond comes
  registered to you however, it has coupons
  attached which you send in for payment.

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Variety of Corporate Debt
Mortgage Bonds

• Mortgage bonds are backed by real estate and/or
  the physical assets of the corporation.
• The real assets pledged will have a market value
  greater than the bond issue.
• If the company defaults on the bonds, the real
  assets are sold off to pay off the mortgage bond
  holders.

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Variety of Corporate Debt
Equipment Trust Certificates

• Equipment trust certificates are very similar to
  automobile loans.
• When you borrow money for your new car, you make
  a down payment. Then you make your monthly
  installment payments.
• At no time throughout the life of the loan is
  your car worth less than the outstanding amount
  of the loan.

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Variety of Corporate Debt
Equipment Trust Certificates

• Many railroad and transportation companies use
  equipment trust certificates to meet their
  financing needs.
• Usually, 20 of the purchase price is put down by
  the company in the form of a down payment. Then
  the balance is paid off over 15 years.

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Variety of Corporate Debt
Equipment Trust Certificates

• When the company is finished paying off the loan,
  it receives clear title from the trustee.
• If the company defaults on its loan, the
  equipment is sold off and the bond holders are
  paid off.

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Variety of Corporate Debt
Equipment Trust Certificates

• Equipment Trust Certificates are serial bonds.
• That is, each time a payment is made, a portion
  of that payment is interest and a portion of that
  payment is principal.
• In this way, as previously stated, the loan
  amount never exceeds the collateral value.

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Variety of Corporate Debt
Debentures

• Debentures are unsecured promissory notes that
  are supported by the general creditworthiness of
  the issuing company.
• Because no assets are pledged, these bonds are
  riskier than collateralized bonds.
• As a result, they are often referred to as
  subordinate debt and carry higher interest rates
  and/or other features to make them more desirable
  to investors.

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Variety of Corporate Debt
Income Bonds

• Income bonds will only pay interest if income is
  earned by the issuing company and only to the
  extent that income is earned.
• Income bonds are the only bonds issued where
  failure to pay the interest in a timely fashion
  does not lead to immediate default.
• As a result, income bonds are considered to be
  extremely risky.

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Variety of Corporate Debt
Income Bonds

• In general, income bonds are issued by a company
  in bankruptcy.
• The company facing bankruptcy will meet with its
  creditors (usually bond holders) and agree to
  issue new income bonds in exchange for the old
  bonds.
• Because failure to pay interest would land the
  company back into bankruptcy court, the creditors
  agree that interest will only be paid to the
  extent earned.

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Variety of Corporate Debt
Convertible Bonds

• Convertible bonds are one type of hybrid
  security.
• They are like bonds in that they pay a fixed rate
  of interest and have a maturity date.
• They are also like stock because they give the
  investor an option to convert the bond into a
  specified number of shares of stock.
• The market price of a convertible bond therefore
  depends both on the firms stock price and
  prevailing interest rates.

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Variety of Corporate Debt
Variable Interest Rate Bonds

• Variable interest rate bonds are bonds with
  coupon rates that vary with changes in short-term
  interest rates (like adjustable rate mortgages).
• Usually, the interest rate is pegged to another
  rate such as U.S. Treasury bills.
• In general, the market price of a variable rate
  bond will be less volatile.
• On most bonds, an increase in interest rates will
  result in a decrease in market price.

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Variety of Corporate Debt
Discount and Zero Coupon Bonds

• A zero coupon bond pays no coupon interest from
  year to year the way most bonds do.
• Investors earn their returns by purchasing the
  bonds at deep discounts from the bonds face
  value, and then receiving the full face value at
  maturity.
• Since the return on a zero depends strictly on
  the issuing firms ability to pay the face value
  at maturity, only the most creditworthy firms are
  able to issue them.

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Variety of Corporate Debt
High-Yield (Junk) Bonds

• High-yield bonds are not a different type of bond
  -- simply a bond of lower quality.
• Bonds rated BB (SP) or Ba (Moodys) or lower are
  considered to be junk.
• Junk bonds are usually debentures and are
  subordinated to the firms other debt.
• In general, junk bonds pay around 3 to 4 percent
  higher yields to investors than higher-grade
  bonds.

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Retiring Debt
Serial-Bonds

• A serial bond is simply one in which some of the
  bonds in the issue mature or are retired each
  year rather than all at once.
• Serial bonds are usually used by companies to
  finance costly equipment, or by municipalities to
  finance capital improvements.
• Also, the assets financed are usually used as
  collateral to secure the bonds.

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Retiring Debt
Sinking Funds

• A sinking fund is simply a series of periodic
  payments to retire part of a debt issue.
• In most cases, the periodic payments plus the
  interest earned on those deposits retire the debt
  at maturity.
• In some cases, the firm sets aside funds and
  randomly selects bonds to be called.
• Strong sinking funds set aside a large amount to
  be retired (say 10 per year).

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Retiring Debt
Sinking Funds

• Weak sinking funds will leave most of the issue
  outstanding until maturity.
• This is sometimes referred to as a balloon
  payment.
• Bonds with strong sinking funds are generally
  considered to be less risky than those with weak
  sinking funds.

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Retiring Debt
Repurchasing Debt

• Firms that have outstanding bonds which have
  substantially declined in price and are selling
  at a discount are sometimes repurchased by the
  issuer in the open market.
• Thus, a firm with bonds selling at 500 with a
  face value of 1000 can cut their financing costs
  in half.
• However, this decision must be weighed against
  any alternative uses for the cash used to execute
  the repurchase.

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Retiring Debt
Callable Bonds

• A call feature gives the issuer the right (or
  option) to retire a debt issue prior to maturity.
• Issuers tend to call bonds that were issued
  during a period of high interest rates because it
  gives them the opportunity to refund the debt at
  a lower rate.
• To protect investors, callable bonds usually
  require the issuer to pay a call premium which
  amounts to one year of extra interest expense
  (but usually declines over time).

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Bond Risk
Sources of Risk

• Default Risk
• Risk that the interest will not be paid
• Risk that the principal will not be paid
• Risk that the price of the bond will decline due
  to poor company prospects
• Inflation Risk
• Call Risk
• Interest Rate Risk.

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Corporate Bonds
Bond Ratings
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Contrasting Debt Equity
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Preferred Stock

• Preferred stock is an equity instrument that
  usually pays a fixed dividend and has a prior
  claim on the firms earnings and assets in case
  of liquidation.
• The dividend is expressed as either a dollar
  amount or as a percentage of its par value.
• Therefore, unlike common stock a preferred
  stocks par value may have real significance.
• If a firm fails to pay a preferred stock
  dividend, the dividend is said to be in arrears.

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Preferred Stock

• In general, and arrearage must be paid before
  common stockholders receive a dividend.
• Preferred stocks which possess this
  characteristic are called cumulative preferred
  stocks.
• Preferred stocks are also often referred to as
  hybrid securities because they possess the
  characteristics of both common stocks and bonds.
• Preferred stocks are like common stocks because
  they are perpetual securities with no maturity
  date.

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Preferred Stock

• Preferred stocks are like bonds because they are
  fixed income securities. Dividends never change.
• Because preferred stocks are perpetual, many have
  call features which give the issuing firm the
  option to retire them should the need or
  advantage arise.
• In addition, some preferred stocks have mandatory
  sinking funds which allow the firm to retire the
  issue over time.
• Finally, participating preferred stock allows
  preferred stockholders to participate with common
  stockholders in the receipt of dividends beyond a
  specified amount.

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Preferred Stock

• Two special types of preferred stock include
  adjustable (floating) rate preferred and
  payment-in-kind (PIK) preferred.
• The dividend on floating rate preferred is tied
  to the rate on specified government securities
  and and protects investors from variations in
  interest and inflation rates.
• PIK preferred pays dividends in the form of
  additional shares rather than in cash for a
  specified period after which investors are either
  paid in cash or are given the opportunity to swap
  these shares for more traditional securities.

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Preferred Stocks Bonds Contrasted

• Preferred stocks are riskier than bonds from the
  investor perspective because
• Bond terms are legal obligations
• The investor cannot expect the firm to redeem
  preferred stock for a preset face value. It must
  be sold in the market at an uncertain price.
• Preferred stock prices are therefore more
  variable and thus riskier than bond prices.

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Disadvantages of Preferred Stock

• Preferred stock offers no protection from
  inflation.
• Preferred stock tends to be less marketable than
  either bonds or common stock resulting in a large
  bid-ask spread.
• Inferior position to bondholders.
• Yields are insufficient for most (non-corporate)
  investors to justify risk.

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Common Stock
Stockholder Rights
Voting Rights
In general, voting rights are relatively
meaningless since share ownership is very widely
dispersed among a large number of individual
shareholders. As a result, directors and top
management are relatively well-insulated.
This has begun to diminish to some extent in
recent years due to the rapid expansion of large
institutional investors such as mutual funds and
insurance companies.
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Common Stock
Stockholder Rights

• Voting Rights
• traditional voting

Under traditional voting, each share owned gives
the shareholder the right to vote for one
individual for each set on the board of directors.
Under this system, if the majority of
shareholders vote as a block, the minority could
never elect a director.
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Common Stock
Stockholder Rights

• Voting Rights
• traditional voting
• cumulative voting

This system empowers minority stockholders by
permitting each stockholder to cast all of his or
her votes for one candidate for the firms board
of directors.
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Common Stock
Stockholder Rights

• Voting Rights
• traditional voting
• cumulative voting
• Example

Under traditional voting, a shareholder with 100
shares can vote 100 shares for each of 5 members
of the board of directors.
Under cumulative voting, a shareholder with 100
shares can vote 500 shares for just one member
running for the board of directors.
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Common Stock
Stockholder Rights

• Voting Rights
• Preemptive Rights

A preemptive right gives a shareholder the right
to maintain his or her proportionate share of the
company by requiring that all new shares issued
must be done so through a rights offering.
Under a rights offering, a shareholder who owns
10 of the shares outstanding has the right to
purchase 10 of any additional shares issued.
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Common Stock
Stockholder Rights

• Voting Rights
• Preemptive Rights
• Proxies

Proxies are frequently used in the voting process
since many smaller stockholders do not attend the
annual meeting. Shareholders must sign a proxy
statement giving their votes to another party who
will then vote their shares.
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Common Stock
Dividends

• Payment of dividends is at the discretion of the
  Board of Directors.
• Dividends may be made in cash, additional shares
  of stock, and even merchandise.
• Stockholders are residual claimants -- they
  receive dividend payments only after all claims
  have been settled with the government, creditors,
  and preferred stockholders.

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Common Stock
International Stock Issues

• The international market for common stock is not
  as large as that for international debt.
• However, cross-border trading and issuance of
  stock has increased dramatically during the past
  20 years.
• Much of this increase has been driven by the
  desire of investors to diversify their portfolios
  internationally.

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Common Stock
International Stock Issues
Stock Issued in Foreign Markets

• A growing number of firms are beginning to list
  their stocks on foreign markets.
• Issuing stock internationally both broadens the
  companys ownership base and helps it to
  integrate itself in the local business scene.

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Common Stock
International Stock Issues
Foreign Stocks in U.S. Markets

• Only the largest foreign firms choose to list
  their stocks in the U.S. because of the rigid
  reporting requirements of the U.S. markets.
• Most foreign firms instead choose to tap the U.S.
  markets using ADRs -- claims issued by U.S. banks
  representing ownership shares of foreign stock
  trading in U.S. markets.